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I Was Wrong About China

If it looks too good to be true, it probably is!

As a country, China's importance to the global economy is only growing, and its still-high GDP growth and need for raw materials has thus far been enough to keep the economic gerbil running on its wheel despite growing macroeconomic uncertainty.

In 2007 and 2008, buying into fast-growing Chinese companies was akin to buying an Internet company back in 2000 -- you could do no wrong. Growth prospects were high, results were handily coming in ahead of what few expectations existed on Wall Street, and forward earnings multiples were significantly lower than U.S.-based companies that were operating in the same sector. Things looked too good to be true from the start, and as I soon found out, they absolutely were.

Before we get into why I was wrong on China, I want to give you a taste of just how wrong I was. Last October, I created a Motley Fool CAPS account dedicated to my belief that Chinese-listed companies were set to outperform over the next three years and I even dedicated a blog to this assertion. Over the course of a few days, I filled this CAPS account with 200 Chinese stocks and figured in three years I would have achieved an accuracy of 70% and around 4,000 CAPS points. What I have done in just over a year is achieve almost the lowest possible CAPS ranking with an accuracy of just 13.5% and a CAPS score in excess of minus 8,000!

Why I was wrongI wouldn't say there was just one reason that I could point to that explains why I wrongly placed my bet on China's outperformance, but rather a series of miscues.

My first mistake was in not realizing that results which seem too good to be true often are. I can think back and remember when Orient Paper(AMEX: ONP), Telestone Technologies(Nasdaq: TSTC), and China Sky One Medical were some of my top picks from China, and they turned out to be absolute disasters. These companies traded at mid-single digit forward earnings multiples in most cases and often had very limited analyst coverage. Rather than focusing on why they traded at a discount to their peers I just assumed the market had overlooked them and blindly bought into the hype -- mistake No. 1.

The second mistake I made was assuming that corporate governance in China was comparable to what we're used to in the United States. Oh, how wrong I was on that point; and not just wrong, but way-out-of-the-ballpark wrong! Chinese corporate laws are evolving constantly, but they are still considerably more relaxed than in the U.S., and as such have fostered corruption to a level we haven't seen since the savings and loan scandals of the 1980s. The result has been a scandalous lineup of fraud allegations against companies including RINO International, ChinaMedia Express, and even a former holding of mine, Jiangbo Pharmaceuticals, just to name a few. In short, I bought into these stories without really understanding how these companies were run -- mistake No 2.

The final mistake I made was in chasing the past performance of these stocks. As I mentioned, 2007 and 2008 were generally good years for Chinese-based stocks listed in the U.S., and I figured that as long as China's GDP was growing rapidly, there could be little doubt that any company with the name "China" in its title was heading higher. Again, how wrong I was. Rather than looking forward, I was placing bets on results that were already in the books -- mistake No. 3.

What I've learnedThe great thing about the stock market is you always have a second chance to get better and learn from your mistakes. Let's take a look at my three miscues and I'll give you a brief synopsis of what I learned.

Mistake No. 1: If a stock looks too good to be true, it probably is.If you've ever wondered why I'm such a skeptic and not a diehard bull like many of my Motley Fool colleagues, it's because of China. This mistake taught me to criticize every stock I own and look for what could go wrong rather than assume that everything is peachy. Not only will you understand what can affect a company better, but you'll have even more conviction with your purchases.

Mistake No. 2: Assuming China's corporate governance is the same as in the U.S.One of the most important rules in investing is to know your management team, and I failed brutally on this account. Understanding that different countries could have different laws in place is important to know, but having a transparent and trustworthy management team is paramount to your stock's success.

Mistake No. 3: Chasing past performance.There's a reason financial brokerages put a disclaimer on their front page alerting you that past performance is no guarantee of future results: The stock market is forward looking and we as investors need to be as well. It's great that Hanwha SolarOne(Nasdaq: HSOL) turned a profit over the trailing-12-month period, but its prospects going forward look bleak. Looking forward rather than backward is the key to long-term investing.

What to do nowAfter reading about my experiences with China, you might assume that I have no desire to ever invest in a Chinese company again, which is actually not the case. There are plenty of investment-worthy China-based stocks that have built long track records of trust, have transparent management teams, and are still growing like wildfire, such as Baidu(Nasdaq: BIDU), SINA(Nasdaq: SINA), and Sohu.com(Nasdaq: SOHU). While my opinion on these three is mixed, one thing I am sure of is that I will be investing in China again. The difference is that this time around, I'm armed with better information than I was before.

Author

A Fool since 2010, and a graduate from UC San Diego with a B.A. in Economics, Sean specializes in the healthcare sector and investment planning. You'll often find him writing about Obamacare, marijuana, drug and device development, Social Security, taxes, retirement issues and general macroeconomic topics of interest. Follow @TMFUltraLong